Sei sulla pagina 1di 5

MATH4512 – Fundamentals of Mathematical Finance

Homework Three

Course instructor: Prof. Y.K. Kwok

1. Suppose there are n mutually uncorrelated assets. The rate of return on asset i has
variance σi2 . The expected rates of return are unspecified at this point. The dollar

n
amount of asset i in the market is Xi . We let T = Xi and then set xi = Xi /T , for i =
i=1
1, 2, · · · , n. We take the market portfolio in normalized form to be x = (x1 , x2 , · · · , xn ).
Find an expression for the beta βj in terms of the xi ’s and σi ’s.
2. In Simpleland there are only two risky stocks, A and B, whose details are listed in the
following table.

Number of Price Expected Standard


shares out- per rate of deviation of
standing share return return
Stock A 100 $1.50 15% 15%
Stock B 150 $2.00 12% 9%
1
Furthermore, the correlation coefficient between the returns of stocks A and B is ρAB = .
3
There is also a risk-free asset, and Simpleland satisfies the CAPM exactly.
(a) What is the expected rate of return of the market portfolio?
(b) What is the standard deviation of the market portfolio?
(c) What is the beta of stock A?
(d) What is the risk-free rate in Simpleland?
3. Some risky assets are not easily marketable. For example, human capital, an individual’s
future lifetime income, cannot be sold. Some assets such as one’s house may not be sold
for psychological reasons or inertia, so it may be considered non-marketable. When some
assets are not marketable, the CAPM can be reformulated. Show that the equilibrium
rate of return on asset i is given by
Ri = r + βi∗ (Rm − r)
where
cov(Ri , Rm ) + (VN /Vm )cov(Ri , RN )
βi∗ = 2 + (V /V )cov(R , R )
,
σm N m m N
VN = value of all non-marketable assets, Vm = value of marketable assets, and RN =
one-period rate of return on non-marketable assets.
Hint: Let wj be the weight of the j th risky asset within the universe of marketable assets
and let wN = VN /Vm . The objective function to be minimized is
( J )

var wj Rj + wN RN .
j=1

Here, w1 , · · · , wJ are the control variables while wN is not a control variable. The
model has close resemblance to the asset-liability model.

1
4. Let rj denote the equilibrium rate of return of risky asset j as deduced from CAPM and
S be its equilibrium price. Let P0 be the market price of asset j and Pee be the random
return of the asset. Let rj′ be the rate of return as deduced from the market price of the
asset. Let rm denote the equilibrium rate of return of the market portfolio. Show that
( )
′ S cov(Pee /P0 , rm )
E[rj ] − rf = (1 + rf ) −1 + 2
(µm − rf ),
P0 σm
2
where σm = var(rm ) and µm = E[rm ], rf is the risk free interest rate.
Hint: First, find the relation between E[rj′ ] and E[rj ]. Note that they are the same if
and only if S = P0 .
5. Take a subset of N risky assets from the financial market and assume their beta values
to be β m = (β1m β2m βN m )T . We would like to construct the market proxy m b from
b is one and β m
these N risky assets such that the beta of m b = β m , that is, β jm = βj m
b for
all j. Consider the following minimization problem
min wT Ωw
w
β Tm w=1
where Ω is the covariance matrix of the random returns of the N assets. The constraint
b is one. The first order conditions give
indicates that the beta of the market proxy m
Ωw − λβ m = 0 and β Tm w = 1.

Show that
1 Ω−1 β m
λ= T −1
and w∗ = .
βmΩ βm β Tm Ω−1 β m
We set the market proxy to be w∗ . Check whether β m
b = β m , where β m b · · · βN m
b = (β1m
T
b) ,
cov(rj , rm
b)
and recall βj m
b = 2
.
σm
b

6. Assume that the following two-index model describes the rate of return of asset i as
Ri = b1i I1 + bi2 I2 + ei .
Assume that the following three portfolios are observed.

Portfolio Expected Return bi1 bi2


A 12.0 1 0.5
B 13.4 3 0.2
C 12.0 3 −0.5

According to the APT, the expected rate of return Ri is given by


Ri = λ0 + λ1 bi1 + λ2 bi2 .
Determine λ0 , λ1 , and λ2 .
7. Someone who believes that the collection of all stocks satisfies a single-factor model with
the market portfolio serving as the factor gives you information on three stocks which
make up a portfolio. (See Table.) In addition, you know that the market portfolio has an
expected rate of return of 12% and a standard deviation of 18%. The riskfree rate is 5%.

2
(a) What is the portfolio’s expected rate of return?
(b) Assuming the factor model is accurate, what is the standard deviation of this rate
of return?

Simple Portfolio
Stock Beta Standard deviation of random error term Weight in portfolio
A 1.10 7.0% 20%
B 0.80 2.3% 50%
C 1.00 1.0% 30%

8. Two stocks are believed to satisfy the two-factor model

r1 = a1 + 2f1 + f2
r2 = a2 + 3f1 + 4f2 .

In addition, there is a riskfree asset with a rate of return of 10%. It is known that
r1 = 15%, r2 = 20%. What are the values of λ0 , λ1 and λ2 for this model?

9. David and Sue are portfolio managers for a defined benefit pension fund that has $20
billion dollars invested in U.S. stocks. A large portion of these funds are passively invested
to match the returns of the S & P 500 index. Recently, top administrators of the pension
plan have asked David and Sue to develop an active investment strategy that will initially
be used on a small portion of the $20 billion. If the active strategy they develop is
successful, it will be used on a larger percentage of the $20 billion. David and Sue have
decided to use the concept of arbitrage pricing theory (APT) in developing their active
investment strategy.

(a) They decide their initial APT model will include the following three common factors:
N = percentage change in consumer non-durable good purchases
D = percentage change in consumer durable good purchases
I = percentage change in consumer price inflation
Following the standard way of symbolically expressing the APT, they write the
following equation for stock i:
eit = a0t + biN (N
R et ) + biD (D
e t ) + biI (Iet ) + eit .

et .
Define what the following terms mean: a0t , biN , N
(b) After considerable statistical analysis, they develop the following factor estimates
for stock 1:
b1N = 1.0; b1D = 1.5; b1I = −0.5.
They believe a01 should be the one-year risk-free rate at 4%. In addition, they believe
the security markets expect N, D, and I to be the following during the next year.

Factor Expected value


N 2.0%
D 3.0%
I 1.5%

If these assessments are correct, what expected return does the market expect on
stock 1 during the next year?

3
(c) David and Sue agree with the expected value of N and I. But they believe the
percentage growth of durable consumer purchases (common factor D) during the
next year will be 5.0%. How should they use this opinion in developing their active
management strategy?
(d) What is the role of the eit term in the equation?
(e) What types of difficulties do you see in using the APT to develop an active manage-
ment strategy?
10. An investor purchased one share of Goldman Sachs (GS) at $100 at T = 0. She again
purchased one more share of GS at $120 at T = 1. She received total dividend of $2 at
T = 1 and a dividend of $3 per share at T = 2. The investor sold the shares at T = 2
for a total consideration of $260 (or $130 per share). What are the money weighted and
time weighted returns?
11. There are two funds A and B. Fund A has a sample mean of 0.13 and fund B has a
sample mean of 0.18, with the riskier fund B having double the beta at 2.0 as fund A.
The respective standard deviations are 15% and 19%. The mean return for the market
index is 0.12 with a standard deviation of 8%, while the riskfree rate is 0.08.
(a) Compute the Jensen Alpha for each fund. What does it indicate to you?
(b) Compute the Treynor Ratio for the funds and the market. Interpret the results.
(c) Compute the Sharpe ratio for the fund and the market.
(d) How would you comment on the performance of the two funds?
12. Suppose the returns and corresponding beta values for two assets (A and B) are as
indicated on the following graph:

(a) Compute the Treynor Ratio for A and B. Interpret the results.
(b) Compute the Jensen Alpha for A and B. Interpret the results.
(c) Suppose one manager had selected a portfolio represented by A and another manager
had selected a portfolio represented by B. Would you feel confident in evaluating
the manager’s relative performance with the Treynor or Jensen results?

4
13. Consider the following graph:

(a) Compute the Sharpe Ratio for A and B. Interpret the results.
(b) Suppose there is no borrowing of riskfree asset. How would your interpretation of
A’s performance be affected?

14. Two managers both are awarded a Jensen Alpha of 3 percent on their performance.

(a) Does this indicate a good performance or a poor performance?


(b) What shortfalls would you point out in this index?

15. Suppose you plot the performance of two funds in (β, µ) diagram in relation to your
estimated security market line, and you find that they line up perfectly equidistant above
the line. At a later date you discover your estimate of the security market line had too
large a slope because you used the wrong riskfree rate; that in fact, the true SML had a
very mild incline. What does this affect your evaluations of these two funds?

16. What are the advantages and disadvantages of the Jensen Alpha, Treynor Ratio, and
Sharpe Ratio? Discuss the scenarios where these three measures work well, respectively.

Potrebbero piacerti anche